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10 Simple Mortgage Application Tips for Self-Employed Home Buyers
Obtaining a mortgage is one of the most challenging things you’ll ever do. You’ll need to prove you have steady income over a couple of years or longer, keep your debts low and in control, and safeguard your credit.
Freelancers or self-employed individuals are in for a bigger challenge. According to a recent survey, freelancers, gig workers and small business owners account for roughly 28% of the workforce. Just like someone in a traditional job role, self-employed mortgage applicants would have to provide proof of steady income for two years, a nearly impossible challenge when you consider how gig or freelance income can vary from one month to another.
Although mortgage rates are at an all-time low, presenting a favorable opportunity to borrow, unemployment claims are the highest in history. Paired with the economic uncertainty, lenders have tightened their qualifications for borrowers interested in a mortgage, adding further challenges for the self-employed.
Does this mean that taking advantage of the record-low mortgage rates at this time is impossible if you’re self-employed? Not if you know alternatives and how to prepare to qualify for a home loan.
What are lenders looking for?
The pandemic has changed how mortgages are written. In general, documentation must be more recent than before — with bank statements and financial document requirements changing from four months to two months in recency. Some banks have pushed the minimum credit score accepted up to 680 or higher. Self-employed applicants are given some allowances for declining income due to the coronavirus, but still need to show consistent historical income.
The changes are not all negative. While self-employed applicants may face more stringent guidelines to qualify, the mortgage application process has gone mostly digital, making it easier to organize and submit documents. The majority of home lenders will allow you to provide downloaded bank statements and scanned tax returns by uploading them with your application, saving you time and effort.
The documentation required to apply for a mortgage is the same for someone who is self-employed as it is for someone submitting a W2. Refer to this checklist of recommended documents and items a lender will review:
- Two years of federal income tax returns (personal and business)
- Recent personal bank statements
- Recent business bank statements
- A year-to-date profit-and-loss statement (self-employed and business owners)
- Your business license
- Letter of verification from a CPA that you’ve been in business for at least two years
- Your Social Security number
Self-employed people are most challenged when it comes to providing two years worth of tax returns showing income. Hussein Ahmed, CEO of Oxygen, a bank focusing on freelancers and self-employed “free thinkers”, says the largest challenge for someone without W-2s is “the variability of their income.” Ahmed adds, “Banks typically want to see a steady income, and this is something freelancers just don’t have.”
He advises self-employed persons seeking a mortgage to “have detailed documentation for at least the last few years.” A banker may average out income over longer than two years for a clearer financial picture.
10 tips for the self-employed seeking mortgage approval
Financing a home when you’re self-employed is attainable with a little preparation and research. Consider the following ten tips that could improve your odds.
1. Choose a lender you have good history with
Developing a history with a bank can work in your favor. Loans are still underwritten by individuals, and a bank you have a long working relationship with may consider your unique case.
Ahmed explains, “Don’t wait to start your relationship with a financial institution.” He strongly recommends checking in with your current bank more often and making yourself known. “Having a banking partner who knows you and your unique situation can make all the difference,” he says. Your banker may even have insight on how his or her bank’s lending works and what you can do to improve your chances of qualifying for a mortgage.
2. Check out smaller banks and credit unions
Your local credit union or a small bank may provide a personal banking experience and, subsequently, be more willing to finance your home purchase. The unique service you offer or the number of people you employ may be favorable factors when they’re evaluating your mortgage application.
Smaller lenders also tend to manage their own home loans, rather than selling them to bigger institutions like Fannie Mae, so qualifications may be more reasonable. You may even get a better interest rate or lower closing costs through a credit union since credit unions are not-for-profit institutions and tend to charge lower fees than a standard bank.
3. Work with a mortgage broker
If you have a unique situation or tend to have large swings in income, you may need a specialist who understands your situation. Unfortunately, banks may not always be the best sources of help. A mortgage broker works independently and isn’t tied to one bank and can shop your application around to multiple banks to find you the best home loan.
They’ll be able to review your application and documents and help you strategize to create an application package with the highest odds of approval. They’re typically free — they make a commission from the lender when you’re approved for a mortgage. Look for a mortgage broker that knows the ins and outs of being self-employed. In most cases, they’re self-employed too and understand you.
4. Documentation, documentation, documentation!
Lenders need to see at least two years of steady income documentation. Keep track of your personal documents and make sure you categorize them separately from your business ones. Important documents are bank statements, income taxes, balance sheets, profit and loss statements.
If your recent statements and returns don’t show steady income, you could also include letters or signed testimonials from current paying clients who can vouch for your business. Other options that may help your case are a profit loss for the current year to date if it shows an improvement in income or recently-signed work contracts that may not reflect income yet.
5. Limit your tax deductions
Self-employed persons are privy to many tax deductions and write-offs. However, the number of deductions many freelancers claim ends up leaving them filing a tax loss to avoid having to pay taxes. Heather McRae, Senior Loan Officer at CFS Mortgage in Chicago warns, “If you’re writing off all the income you make to pay as little as possible in taxes, this hurts you when trying to get a mortgage.”
If you’re planning on buying a home soon, don’t be as aggressive with the tax deductions, even if it costs you more in taxes for the year. As for previous years, you may amend your prior tax returns to show higher past income. Consult with a tax professional before you amend past returns — if you remove some of your previous deductions to look better on paper, you will owe tax and likely have to pay late fees for the amended tax due.
6. Clean up your credit
Income and credit score are the two most important factors behind getting approved for a mortgage, regardless of whether you’re traditionally employed or a freelancer. Review your credit report for mistakes and dispute any errors. Pay down as much debt as possible in advance of applying for a mortgage. Low credit utilization of around 30% or less can boost your score. Aim for less than 20% when you’re self-employed — good to excellent credit could make up for some of the limitations you face when you can’t provide steady income.
7. Consider buying the home with your partner
We’ve emphasized how lenders are primarily looking for steady-income borrowers. If you’re in the early stages of your small business and showing a history of growing income over the last couple of years isn’t possible, consider buying a home with your partner if they’re employed and receive a W-2 for their income. You’re more likely to be approved based on your partner’s regular income.
8. Pay yourself a W-2 wage versus an owner’s draw
Small business owners tend to pay themselves sporadically in the early years. Many choose to issue an owner’s draw when they can afford it, such as right before the holidays or after a large commission or sale. Draws have several drawbacks. First of all, a draw may not be consistent enough for a mortgage underwriter to consider it as income. Second, you’ll also need to pay self-employment taxes on draws.
A business can’t take advantage of any tax write-offs when paying out an owner’s draw. It’s better to set owners up as salaried W-2 employees, even if the amount is smaller. It will be better for company tax write-offs and will give the salaried owner the advantage of showing steady income when applying for a mortgage.
9. Offer a larger down payment
If your income is inconsistent, but you can save enough money for a larger down payment, you may improve the chances of qualifying for a mortgage. Most lenders require 20% down. Offering to pay a higher amount reduces the amount of the loan and the lender’s risk. An applicant with a strong financial standing may be able to offset an irregular income history.
10. Confirm your average yearly income
Speak with your lender about any gaps in your income or work in the past. You may be able to provide a letter explaining why there was a gap. Some reasonable explanations for a gap may include maternity or disability leave. Lenders may be willing to consider valid reasons for why your annual income was interrupted.
Alternative mortgage options for self-employed applicants
If the mortgage process through a bank or traditional home loan lender fails, alternative funding options are available. As mentioned, a mortgage broker has a wide array of tools and lending options to help you close on a home. The options aren’t limited to traditional banks and lenders. Anthony De Guzman, Co-Founder of the online mortgage broker site Breezeful.com, says, “Chat with your broker regarding private mortgage, rent-to-own programs and other alternative forms of lending.” Here’s more on the alternatives:
Bank statement programs
Some banks are willing to work with self-employed borrowers by foregoing tax returns and focusing on bank statement history. You’ll provide your personal or company’s bank statements as proof of income. Your overall business and personal cash flow or the amount of money you have in savings and investments will be considered instead of taxable income.
There has been a surge in home refinances due to COVID-19. The virus itself isn’t responsible — it’s the historically-low interest rates. Self-employed borrowers may find it’s harder to qualify at this time. With the current high number of refinances, underwriters may not have the time to consider mortgage applications that don’t check off all the boxes.
A personal loan may be an alternative, although the option might not be suitable for properties of more than $100,000. You can borrow the money from loved ones and work with a mortgage broker who contacts investors willing to lend money to earn the loan’s interest. You may pay a higher interest rate, but it may be worth your while to lock in your home.
Some homeowners or landlords would be willing to consider selling you their home and financing the mortgage themselves. Instead of paying a mortgage to a lender or bank, you’d pay the former owner of the home. This method is more flexible. You can agree on a down payment and a monthly payment amount, but you’ll need an attorney to help you draft the contract. In many cases, the owner won’t agree to a 30-year loan, so be prepared to pay off the rent-to-own agreement faster.
If you go with an alternative home loan, you can always refinance a traditional mortgage through a bank or lender once your work and income stabilize. An alternative loan may be a good entry-point into buying a home while you establish yourself as self-employed.
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